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If You Must Trade, Follow These Five Rules

It might surprise readers given my background as a former Wall Street trader, but I do not recommend short-term trading. You are unlikely to generate true alpha, and you spend so much of your time and effort for potentially suboptimal returns. Actively managed mutual funds and hedge funds have finance MBAs from prestigious institutions, armies of research analysts working for them, and amazing computer setups that would make a gamer drool.

But even as we complain about patients when they think they know more than the doctor because they Googled their symptoms before the visit, physicians routinely think they can beat professional investors at their own game during their lunch break or on their iPad in the OR. But I think anyone who spends any significant time following the financial markets is going to want to at least try their hand at trading. We all have to make the mistakes ourselves before we go back to our day jobs being physicians and earning returns better than 90% of mutual fund managers by investing in a diversified portfolio of low-cost index funds (I recommend the three-fund portfolio).

So if you’re going to trade, here are some tips to give yourself the best chance of success (which I define as losing the least amount of money before you quit).

1. Limit Your Trading Account to 5% of Your Portfolio

Your short-term trading account is your play account, and so the standard advice surrounding gambling applies here. Don’t trade money you cannot afford to lose. Most traders will take concentrated (uncompensated) risk in just one or a few stocks, which means you are at high risk of experiencing large whipsaws in your portfolio. Even the trading websites tell you to limit the amount you can lose on any individual trade to 2% of your trading capital. I would limit your play account to just 1-2% of your portfolio, but if you must, you can allocate up to 5%.

2. Trade in your Retirement Portfolio Only

This is critical. You must trade in your retirement portfolio only. Since you cannot trade individual stocks in 401k/403b accounts, this means traditional or Roth IRAs. Gains from trading in a taxable account will be considered short-term capital gains income, which is taxed at the same rate as ordinary income. For the typical attending physician investor, that would be a 33% tax rate. Your index fund portfolio will be taxed at a 15% for long-term capital gains rate. This is why you should do your trading in your retirement portfolio, and your index-fund investing in your taxable account.

This advice is counterintuitive, since most people would prefer to try to make short-term trading gain in the taxable account, which can be immediately withdrawn and spent, rather than in the retirement account, which is money you are supposed to use decades down the road. Part of the allure of trading is the idea of making quick gains. But the IRS makes it expensive to cash out your short-term gains. Indeed, that’s the IRS trying to convince you to stop trading.

3. Define your Edge

Before you start trading, you need to define your strategy that will make you excess returns over your index-fund portfolio. If you don’t know the reason you should be earning above-average returns, than any above-average returns you earn is due to luck. The efficient markets hypothesis assumes that there does not exists any edge, but I think the market does reward those who help set the market; namely, those who have superior understanding of the fundamentals, as well as those who set the bid-ask spread (the market makers). Also, those who are able to integrate new news the fastest (i.e. those with the fastest computers who can trade off of Donald Trump’s tweets) will be at an advantage as well.

Note that none of these edges are possible for the physician. But what about our medical knowledge? Does our superior knowledge of the drugs we prescribe give us an edge on how those stocks would move? No, as that would only be our anecdotal knowledge about our prescribing patterns. Your sales rep probably knows more about your prescribing patterns than you do. They also know better than us how the drug is doing in their region. And the pharmaceutical executives know better than the salespeople how the drug is doing on a national or international levels. And these executives talk to the Wall Street research analysts, who spend all of their days, for a salary comparable to or higher than ours, to write reports. Hedge funds and investment banks, not retail investors, pay big money for these reports.

4. Track Your Performance Rigorously (and Honestly)

How can you know how well you are doing and whether you should continue trading if you aren’t keeping track of your performance? Since your trading portfolio should only be a slice of your retirement portfolio, it would be easiest to segregate a certain slice of cash strictly to trading, so you can track how your trading portfolio is doing compared to your index fund portfolio.

It is also important to be honest with yourself about your performance. I have never heard someone talk about losing trades at a cocktail party. Almost no one has below-average returns when there is a message board thread reporting performance.

The other benefit of keeping a trading log is that it can allow you to analyze what trades are working and which are not. The simplest way to do this is to have a spreadsheet of every trade, with your pre-trade rationale, entry point, exit point, and post-trade analysis of what went right or wrong. Simply relying on your “gut” is not a trading edge, even if you are a gastroenterologist and know that your gut is way better than the guts you look at for a living.

5. Always Be Trying to Quit

Trading is like smoking. You get a high from trading gains, but it has long term hazardous effects to your financial health. If after a few months of trading, you have not yet found your trading edge, it’s time to quit. If you feel the urge to assign more than 5% of your portfolio as trading money, it’s time to quit. If you are achieving sub-par performance, it’s time to quit. If trading is taking up too much of your time, it’s time to quit.

What do you think? Have you ever tried your hand at trading? Were you able to make money?

14 thoughts to “If You Must Trade, Follow These Five Rules”

  1. I like your articles. They are lovely. You are an excellent writer. I look forward to them everyday. Can you identify yourself? What are you goals for your blog? Where do you practice? What is your age? When are you going to retire? Do you aspire to be the next WCI? How many posts are you going to do a week?

  2. I really enjoyed reading this post. Right now I am currently trading 10% of my after tax portfolio. For the most part I saw some trends like utilities going up and thought that oil looked too cheap last year. But I am definitely more of a fan of passive index funds unless I see what I perceive as a no brainer stock deal.

    1. Sounds like you are doing well with your play money account. It’s tough with so-called “no-brainer” stock trades; for example, it was a “no-brainer” that the stock market would fall if Donald Trump won the presidency. We all know how that trade turned out.

  3. Great article. I’ve always emphasized point # 4. Most people who track their returns will quit relatively quickly. Even better if you can talk someone into just “paper trading” for a while, or even just writing down their predictions about the future. It’s a very humbling exercise over a year or two.

    1. Agreed. Of course, paper trading isn’t actual trading, because there’s no money, greed, or fear involved, but many people will fail even in paper trading (a good thing because they understand the difficulty of trading without losing any real money).

  4. Great rules to live by.

    The only individual stock I own is Berkshire Hathaway. I like the Zero dividend while living in this high tax bracket, and the invite to the annual meeting, although I’m on call this year, unfortunately. Better than 98% of my investments are in passive index funds.

    My “play money” has been invested in a couple startup craft breweries. They’re a lot of fun to be involved with and the dividends are quite liquid (#freebeer).

    Cheer!
    -PoF

  5. Very nice article. I think the finding that people would much rather NOT lose money than make money really holds true for me when considering trading individual stocks. Whenever I get that itch to open up an account and start buying and selling, I think of how much I can lose almost right away.

    I will stick with indexing for the long term. At least I know when I’m doing bad the whole world is doing bad with me!

  6. Hi Wall Street physician – I enjoy your blog as I have physician sibling.
    When I trade and invest (stocks or ETFs) tend look at volume also – steer away from anything without at least 1mm & preferably 10mm/shares daily vol.
    Index and legitimate sector ETFs (SPDRs) offer an “embedded put” to help sleep – unlike individual stocks.

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